The advent of commodity exchange-traded products (ETPs) has revolutionised the way in which investors access commodity markets, providing exposure to both physical spot prices and future returns.
Physical commodity ETPs are backed by a specific quantity of a commodity and provide exposure to movements in underlying spot prices. Synthetic commodity ETPs, on the other hand, generally track indices comprised of underlying commodity futures contracts that continuously reset, or roll, and give exposure to price movements.
The listing of commodity products on regulated stock exchanges has been a pioneering development, providing investors with an efficient method of gaining exposure to changes in the price of commodities without having to take physical delivery. Investors can use ETPs to access individual commodity sector baskets and broad-based, all-commodity exposures.
An ETP is a commonly used umbrella term that includes a couple of different structures, and there are primarily two types in Europe – exchange-traded funds (ETFs) and exchange-traded commodities (ETCs).
ETFs are generally Ucits, which are open-ended collective investment schemes regulated by the Ucits IV Directive that can be marketed and sold to retail investors throughout the European Economic Area. The directive has introduced a standardised framework mandating increased transparency and holding diversification limits.
ETCs are not Ucits in themselves but they are eligible for investment by Ucits, which is why many multi-asset funds have holdings in ETCs.
As they are not restricted by diversification requirements set out in the Ucits IV Directive, they can offer specific exposures to commodities and currencies that ETFs cannot. This is one of the main reasons why most commodity ETPs are structured as ETCs.
Precious metal ETCs are commonly structured physically, whereas most other ETCs – such as those offering exposure to crude oil or agricultural commodities – will be structured synthetically.
Physical gold ETCs are backed by bullion, which is stored in a vault. It is important to check if the metal is held in allocated form, as this means it cannot be lent out and that an independent vault inspector inspects it.
In contrast, synthetic gold ETCs do not hold physical bullion and instead track a gold futures index, which provides exposure to price movements in the underlying gold futures contracts.
Synthetic ETPs are backed by swaps, where the issuer enters into a swap agreement with a counterparty that contracts to provide the return of the underlying index. The swaps are often collateralised, which means the credit risk to the swap counterparty is being mitigated.
Investors should understand that physical and synthetic commodity ETPs offer exposure to spot and futures markets, respectively. Returns in physical precious metal ETCs should reflect price movements in the underlying spot markets for a given commodity, less fees.
In contrast, the performance of synthetic commodity ETCs should reflect the total returns of futures indices, which comprise the price movements in the underlying commodity futures contracts, the roll return – cost or benefit of rolling a futures contract to maintain continuous exposure – and the collateral yield – interest rate of a fully funded commodity position – less fees.
Investors can use precious metals as a potential source of diversification within portfolios. Research has demonstrated that price movements in commodities, particularly precious metals, bear little relation to price movements in traditional asset classes, such as equities and fixed income.
The diversification benefits of precious metals, in particular gold, during some of the worst drawdowns in the S&P 500 index, show they provide a much-needed buffer to portfolios. Geopolitical risks can often trigger uncertainty in global equity markets and precious metals may be used as a risk hedge within portfolios.
ETPs have democratised the investment landscape for private investors by offering access to a wide variety of asset classes. Unlike unit trusts and open-ended investment companies, ETPs trade on stock exchanges, enabling investors to trade products with the same ease as they would with a stock.
Precious metal ETPs should offer a cost-effective and convenient solution to investors wanting to access precious metal returns without the hassle of physically holding the metal itself.
Nitesh Shah is research analyst and Rima Haddad is head of UK institutional sales at ETF Securities
Expert view
Jason Hollands, managing director at Tilney Bestinvest, is cautious on the outlook for precious metals in the current environment:
“Precious metals, and gold in particular, are typically seen as a store of intrinsic value during periods when paper currencies are being devalued. But after years of money printing, the US Federal Reserve has now ceased its quantitative easing programme and is expected to start hiking [its interest] rate again, which means the backdrop for holding these assets is becoming less favourable.
“An environment of rising bond yields and a potential strengthening of the US dollar is not supportive for gold and other precious metals. First, there is a well-established inverse relationship between the dollar and gold, with a stronger dollar being bad news for gold. Second, when yields on treasuries and other sovereign bonds are rising – as they have been fairly aggressively in recent months – the opportunity cost of holding a zero-yielding asset such as gold is painful.”
Mr Hollands recommends the following funds for those determined to invest in gold and precious metals:
• iShares Physical Gold ETC – for exposure to bullion prices hedged back into sterling;
• BlackRock Gold and General – for exposure to gold mining shares;
• iShares Physical Platinum ETC – for exposure to the platinum market.
